India: Indemnification Issues In Private Equity Exits

The period from 2006 to 2011 witnessed a significant inflow of
private equity investment into India, making it the second most
favoured investment destination after China. However, the
subsequent decline in capital markets had led to a shift in exits
from public offerings to other exit routes such as third party
sales which are beset with its own set of challenges, especially in
light of the uncertainty around treatment of withholding tax
brought about by the Vodafone case. There were several exit related
deals that hit a dead end during this period after long drawn
negotiations due to differences between parties in arriving at the
manner of dealing with withholding tax and related mitigating
factors.

The Vodafone Case.

The genesis of the uncertainty around the treatment of
withholding tax involved the acquisition by Vodafone Netherlands of
CGP Investments Holdings Ltd (CGP)., a company registered in the
Cayman Islands and controlled by the Hutchison Group for a
consideration of USD $11 billion. As part of this overseas
acquisition Vodafone also acquired Hutchison Essar Limited (HEL), a
subsidiary of CGP in India. Under Indian tax laws, liability to
withhold tax is upon the purchaser and default of such obligation
makes such payer a defaulter and consequently liable for the
principal sum, interest and penalties. As Vodafone Netherlands did
not withhold tax on the sale consideration paid to CGP, Indian tax
authorities alleged that the acquisition of HEL via CGP
(the Cayman entity) by Vodafone Netherlands was structured as such
to avoid tax. Indian tax authorities contended that in substance,
the acquisition (of CGP) pertained to Indian assets represented in
HEL, and accordingly raised assessments demanding withholding tax
to the tune of $2.1 billion, representing capital gains made by the
seller.

In dealing with this matter, the Bombay High Court largely
upheld the tax department's demand and observed that though the
isolated sale of CGP shares is not taxable in India, the
transaction has to be given a purposive intent. It further held
that the transferred assets also represented 'rights and
entitlement' (by way of use of the Hutch brand, non-compete
agreement, loan obligations, option for acquiring additional 15%
interest in HEL, etc.) and not the isolated sale of CGP's
shares.

On appeal the Supreme Court concluded that the transfer of
shares in CGP did not result in the transfer of a capital asset
situated in India, and gains from such transfer could not be
subject to taxation in India. Although the Supreme Court's
decision came as a relief to private equity and financial
investors, this case has led to a change in the manner in which
indemnities, in particular with respect to tax, in exits are dealt
with.

After Effects on Exits.

Considering the exit related contingencies that investors have
to deal with, as was demonstrated in the Vodafone matter, it is
paramount that adequate risk mitigators be negotiated with care and
adopted in PE exits. Some of the points for consideration
include:

Tax withholding by
Purchasers, which has emerged as one
of the key points of discussion considering the tendency of tax
authorities to challenge treaty benefits in the absence of
'real substance' of companies situated in favorable tax
jurisdictions. Also, the judiciary's interpretation of existing
taxation laws differently in matters such as the Vodafone case,
Azadi Bachao Andolan case (where the Supreme Court validated the
benefits of the Treaty for residents of Mauritius, subject to there
being a valid tax residency certificate issue by the Mauritian
Government), and the Aditya Birla Group case (in which the Bombay
High Court dismissed the writ petitions filed by Aditya Birla Nuvo
Limited, New Cingular Wireless Services Inc., in relation to
transfer of shares of an Indian joint venture company, Idea
Cellular Ltd. (ICL) and also the transfer of shares of a Mauritian
company which held shares in ICL and expressed its prima facie view
that such sale of shares is liable for capital gains tax in India)
has given credence to this approach.

Tax indemnities by exiting
investors, where earlier the norm
was to specifically exclude PE investors from the requirement of
providing warranties or indemnities (other than with respect to
authority, due execution and the title of securities being
transferred) to acquirers in an exit sale. Pursuant to the Vodafone
case and the proposed introduction of the general anti-avoidance
rules, many PE investors are not completely averse to also
providing tax indemnities to buyers during their exit.

Escrow mechanisms, as
an alternative to providing indemnities in favor of the purchaser
to block applicable tax amounts till clarity on the tax related
position or authorities issuing final clearances.

Clawback provisions,
in situations where an exiting PE investor is not in a position to
provide tax indemnities that survive upto the entire period of
limitation (typically being 7 years) due to expiry of its fund
life, indemnities may be sought from the General Partners (GPs) of
such investor for remainder of such period.

Conclusion.

Negotiation of indemnities in PE exits is beset with a number of
legal, regulatory and operational issues which become even more
critical when exiting investors have had substantial operational
involvement in investee companies. Following the Indian Finance
Minister, Mr. Arun Jaitley, stating in his budget speech of
2016-17, about the government's commitment to not undertake
retrospective amendments to the Income Tax Act, 1961, it would be
interesting to see the manner in which tax indemnities are
structured and evolve going forward. This would be more so in light
of the recent amendments to the Indo-Mauritian Tax Treaty
(introducing levy of capital gains tax on investment in shares
through Mauritius), the government negotiating a similar
arrangement under the Singapore DTAA and the Cabinet approval of
the Agreement and the Protocol between India and Cyprus for the
Avoidance of Double Taxation and the Prevention of Fiscal
Evasion.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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